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CHAPTER # 7 Foreign Exchange Market

Professor Dr. Md. Abu Sina

Definition of FOREX Market




It is a market where transaction in foreign currencies takes place. It is a medium of international trade. In fact, it is an institutional arrangement for transacting business in international currencies. Kindleberger defines a foreign exchange market as, a place where foreign moneys are bought and sold. The foreign exchange market, also known as the forex, FX, or currency market, involves the trading of one currency for another. Foreign exchange markets exist to allow business owners to purchase currency in another country so they can do business in that country.

Participants
There are approximately five different types of entities that use the foreign exchange markets on a daily basis. Commercial banks are the leaders in this market and are the main source of currency transactions. Traditional users refer to entities that do business across national borders. Central banks are the official players in this market, and each country has a central bank to manage its money supply. Brokers work as go-betweens for banks, gotypically during large transactions. And, traders and speculators work to take advantage of short-term trends in shortthe market.

Features

1. 2. 3. 4. 5. 6.

The major features of foreign exchange market are as follows: Bank & customers/clients, Different Banks in FEM, Different Bank of different countries, Central Bank & Commercial Bank, Central Bank of different country, Public of a country.

Where This Happens


Unlike the New York Stock Exchange, which has a physical building, currency exchange takes place all over the world and has no central building. Most transactions are done computer. by phone or computer. Estimates have the international currency exchange driving $180 billion in business per day. The majority of transactions take place in London, New York and Tokyo, with cities such as Singapore, Zurich, Frankfurt and Hong Kong handling transactions as well.

Features of FOREX Market




The FX market is a two-tiered market: two Interbank Market (Wholesale)  About 100-200 banks worldwide stand ready 100to make a market in foreign exchange.  Nonbank dealers account for about 40% of the market.  There are FX brokers who match buy and sell orders but do not carry inventory and FX specialists. Client Market (Retail)  Market participants include international banks, their customers, non-bank dealers, FX brokers, nonand central banks.

Correspondent Banking Relationships


  

Bank A is in London, Bank B is in New York. The current exchange rate is 1.00 = $2.00. A currency trader employed at Bank A buys 100m from a currency trader at Bank B for $200m settled using its correspondent relationship.
Bank A London

$200 100

Bank B NYC

Size
Fx Market =The largest financial market in the world  Most important markets: (daily turnover in 1995)  London $464 billion  NY $244 billion  Tokyo $161 billion  Less important markets:  Singapore, Hong Kong, Zurich ($90-$115b) ($90 Markets: Spot Market Forward Market Futures Market Options Market


What is arbitrage?


Making two markets, by buying and selling between them, a single market is called arbitrage. An arbitrager, usually a large bank, may notice that in N.Y. 1 = $2.42 and in London, 1 = $2.40. An agent will buy pounds in London (for $2.4 billion) and sell them in N.Y. (for $2.42 billion), earning a quick $20 million. The increased demand in London pulls the price up, and the increased supply in New York pushes the price down, equalizing the pound/dollar price.

Types of FEX Market


1. Spot Market  These are the quickest transactions involving currency in foreign markets. These transactions involve immediate payment at the current exchange rate, which is also called the spot rate. The Federal Reserve says the spot market accounts for one-third of all currency oneexchange, and trades usually take place within two days of the agreement. This does leave the traders open to the volatility of the currency market, which can raise or lower the price between the agreement and the trade.

Types of FEX Market


2. Futures Market  As the name implies, these transactions involve future payment and future delivery at an agreed exchange rate, also called the future rate. These contracts are standardized, which means the elements of the agreement are set and nonnonnegotiable. It also takes the volatility of the currency market, specifically the spot market, out of the equation. These are popular among traders who make large currency transactions and are seeking a steady return on their investments.

Types of FEX Market


3. Forward Market  These transactions are identical to the Futures Market except for one important difference---the difference---the terms are negotiable parties. between the two parties. This way, the terms can be negotiated and tailored to the needs of the participants. It allows for more flexibility. In many instances, this type of market involves a currency swap, where two entities swap currency for an agreedagreed-upon amount of time, and then return the currency at the end of the contract.

IMM
The International Monetary Market (IMM), a spin-off spinfrom the old Chicago Mercantile Exchange and largely the creation of Leo Melamed, is today one of Melamed, three divisions of the Chicago Mercantile Exchange (CME), the largest futures exchange in the United States and the second largest in the world after Eurex, Eurex, for the trading of futures contracts and options on futures. The IMM was started on May 16, 1972. Two of the more prevalent contracts traded futures, are currency futures and interest rate futures, specifically, 3-month Eurodollar time deposits and 39090-day U.S. Treasury bills. The other two CME bills. divisions includes the Index and Option Market (IOM) and Growth and Emerging Markets (GEM). All products fall under one of these three divisions.

Elements of Exchange Market


The elements of foreign exchange market are as follows: 1. Foreign currency exchange rate, 2. Rules of foreign currency exchange rates (spot rate, forward rate(advance)) 3. Sales Rules: TT Telegraphic Transfer. BC Bills for Collection 4. Purchase Rules: TT (Clean) TT (Document), OD (Overdraft) 5. Rules of determination of FEMs Local current markets (direct) Foreign current markets (indirect)

Types of Exchange Market


 

  

ARABINDA The selected items / types of foreign exchange markets in Bangladesh are as follows; Central bank and authorized dealer Bank and foreign branches Bank and foreign exchange

Functions


1. 2. 3.

According to M.C. Vaish, Foreign Exchange Market performs the three important functions as under: Transferring the purchasing power Providing credit for financing foreign trade Furnishing facilities for hedging foreign exchange risks

Functions 5. Exchange rates change on a daily basis. The price at any given time is called the spot rate, and is the rate for currency exchanges at that particular time. One can obtain the current exchange rates from a newspaper or online. 6. The fact that exchange rates can change on a daily basis depending upon the relative supply and demand for different currencies increases the risks for firms entering into contracts where they must be paid or pay in a foreign currency at some time in the future.

Functions
7. Forward exchange rates allow a firm to lock in a future exchange rate for the time when it needs to convert currencies. Forward exchange occurs when two parties agree to exchange currency and execute a deal at some specific date in the future. The book presents an example of a laptop computer purchase where using the forward market helps assure the firm that will wont lose money on what it feels is a good deal. It can be good to point out that from a firms perspective, while it can set prices and agree to pay certain costs, and can reasonably plan to earn a profit; it has virtually no control over the exchange rate. When spot exchange rate changes entirely wipe out the profits on what appear to be profitable deals, the firm has no recourse. 8. When a currency is worth less with the forward rate than it is with the spot rate, it is selling at forward discount. Likewise, when a currency is worth more in the future than it is on the spot market, it is said to be selling at a forward premium, and is hence expected to appreciate. These points can be illustrated with several of the currencies. 9. A currency swap is the simultaneous purchase and sale of a given amount of currency at two different dates and values.

What is the Difference Between Forex and Stock?


The Forex market has a lot of advantages compare to stock market:  A Forex trader could make profit through the market no matter if it is bearish and bullish which is different from the capital market, Forex has no strict regulation in speculation, no matter whether it is a long-term or a short-term longshorttransaction there is still a hidden profit, moreover, Forex market is a double-transaction market which means Forex doubletraders could make profit through both upward and downward trend.  Forex traders could obtain a much larger transaction compared to the stock market, through the Forex trading, Forex traders could obtain 100 times larger transaction compared to the stock market. According to the present US situation, if a Forex trader invests $1,000 in the stock market, the trader may obtain $2,000 of stock domination property with a proportion of 2:1, but through Forex trading, a Forex trader can do transaction with a proportion up to 100:1.  Forex trader may make profit from the ordinary news, like the interest rate change, Forex market is closely related to various countries' politic, economy and culture, Forex traders could also obtain profit from other kinds of news, for example interest rate level change, will influence the interest of the Forex deposit.

What is the Difference Between Forex and Stock?




Forex traders could do 24 hours trading. The stock market can only be traded during daytime at a specific time, generally from 9:30a.m. to 4:00p.m.. If you too have your own full time job, then you will face the dilemma - either to give up your full time job or forgo the trading opportunity. But Forex market can be traded 5 days a week and 24 hours a day, Forex traders can trade during their free time which is normally at night after working hour. If a trader analyze based on technical analysis, Forex trading would be much more suitable for such traders because the Forex market has a very large trading volume. Currently the Forex market has daily trading volume of 190 billion Dollar, such giant market will completely digest a fore trader's transaction cash, under such situation the accuracy of the technical analysis would be much higher then any financial market, the chances of using technical analysis to make profit would be much more higher. In the stock market there are hundred and thousand kinds of stocks, then choosing stock will be a very difficult matter. But in the Forex market, the currency combination is extremely limited, this may enable Forex traders to concentrate on these currencies combination, and could follow the trend quickly.

Importance
1.

2.

3.

Foreign exchange solves various problems concerned with the payments for the imports and exports. Foreign exchange situation in one country indicates the strengths of the economy. Shortage of Foreign exchange affects the BOP in an adverse order. It is essential to bring the BOT in order and for achieving it Foreign exchange should be preserved carefully.

Importance
4. Foreign exchange simplifies the complexities out of the vast participation of the nations in the international trade. The mutual payment are easily undertaken as the accepted and predetermined rates already settled by the countries. 5. Foreign exchange rate shows a direct relationship between the prices of the commodities in the national market and the prices in the international market.

Importance
6. The stability in the Foreign exchange rates is of high importance without stability the various problems relating to valuation and pricing of the commodities will become difficult. 7. Foreign exchange rates also speak of the economic soundness of a country. Thus it is clear that the study of Foreign exchange is of the first-rate importance in firstcase one thinks to understand the various problems surrounding the international trade.

Needs of Foreign Trade


1. 2. 3. 4. 5. 6. 7. 8. 9.

It concerns every citizen of a nation Increasing of employment Procurement & disposal of goods Flow of investment Tax payers benefit (Less duty) Economic independence of nations Repayment of debts Rapid growth of the economy Best use of national resources

Needs of Foreign Trade



1. 2. 3. 4. 5.

In addition to the above: Upgrading the standard of living of people Major share and role of export trade in national income Promotion of mutual national interests Factor in political relations & peace Promotion of international collaboration

Problems in foreign trade


There are many problems in foreign trades. 1. Language: When the goods are exported to a foreign country, the labels, informative literature, packing technical handout etc. should be prepared in the language of the century in which the goods are marketed. There should also be salesmen who are versed with that language and know the habits and likings of the people. 2. Standardized Units: In some countries of the world, the units of length, weight, capacity, voltage are not the same. The exporters therefore shall have to see that the goods are prepared and supplied according to the standard specification of the importing country. 3. Sale in foreign currency: Every country has its own currency which is not legal tender in the other country. Buyer abroad prefers to buy the goods in his own currency just as seller prefers to sell in the currency of his own country. The exporter therefore has to calculate the selling price of the goods into the currency units of country where the goods are sold taking into consideration due fluctuations in the foreign exchange rate.

Problems in foreign trade


4. Licenses and documents: When goods are exported or imported a number of documents are to be prepared. 5. Economic risks: It includes the risk of insolvency of the buyers. It is the risk of nonnon-acceptance, risk of exchange rate and risk of changing standards and regulations of the trading countries. 6. Political risks: It involves the risk of cancellation or renewal of trade license. It also includes the war risk, risk of trade tariffs, relations with countries tariffs, and changing political conditions in the trading countries.